CHICAGO — The Securities and Exchange Commission has launched a review of a failed investment by five southeastern Wisconsin school districts in collateralized debt obligations that were intended to establish trusts to pay the districts’ non-pension retiree health care benefits.

The probe comes as the districts’ boards are weighing whether to include in their fiscal 2011 budgets the money needed to repay a collective $165 million of asset-backed notes, backed by the trusts, sold to Depfa Bank Plc to fund participation in the investment in the CDOs. The CDOs included credit default swaps.

The districts put their moral obligation pledge behind the trust notes. As the investment faltered, the value of the trusts’ collateral sank, triggering a default in late 2007 that the districts were required under the loan agreements to cure. They did not cure the defaults and in March Depfa demanded repayment as allowed under its loan agreements.

“The SEC has requested documents from the districts and our clients are cooperating,” said attorney Robert Kantas, who represents the districts in a lawsuit filed against the firms that proposed and structured the trusts.

The commission first approached the districts in late May or early June. The SEC did not return a call to comment.

The Waukesha School District board earlier this month adopted a preliminary budget that does not fund repayment of its outstanding $47.5 million of notes.

That action prompted Moody’s Investors Service on Friday to downgrade the district’s general obligation rating to A1 from Aa3. The agency assigned a negative outlook.

“We were waiting on the results of the budget process,” said Moody’s analyst Henrietta Chang.

The other four districts — the Kenosha Unified School District, the Kimberly Area School District, the West Allis/West Milwaukee School District, and the Whitefish Bay School District — have not yet adopted preliminary budgets, though they are expected to over the next month.

The five invested a total of $200 million — $165 million from the trust notes and $35 million in cash — to help cover their collective $432 million of unfunded other post-employment benefit, or OPEB, liabilities.

After Depfa demanded repayment, Moody’s put the districts’ ratings on negative watch due to “uncertainty about the districts’ willingness and ability to meet the obligations” of their trusts.

Analysts previously downgraded several of the districts after a review of each district’s ability to meet the obligation.

Waukesha chief financial officer Lauri Clifton included the line item to repay the notes in budget documents forwarded to the board — as required under the loan agreement with Depfa — but the board did not adopt the appropriation, which equals 35% of the district’s operating budget.

The district lacks the cash on hand to pay off the notes and a bond refinancing would stretch the district’s borrowing capacity under state caps.

The litigation also drove the board’s decision.

“The board is not convinced that Depfa wasn’t a party to the underlying fraud they believe occurred,” Clifton said.

The districts have asked Depfa to join them as a party to the lawsuit, but the bank has refused. A status hearing is scheduled in Milwaukee County District Court in September. Kantas said he does not expect a trial to occur until late next year or in early 2012.

The defendants in the district’s lawsuit include Stifel, Nicolaus & Co., James Zemlyak, an executive vice president at the firm, and the Royal Bank of Canada Europe Ltd.

The complaint alleges they fraudulently misrepresented the safety of the investments. The firms counter that the districts were aware of the risks.

The districts thought the investments were safe in 2006 when they entered into the transactions. The districts believed the investments were made in highly rated securities that were not exposed to subprime or other market risks.

When the subprime real estate market collapsed and the value of other structured securities fell, the value of the trusts dwindled. The trusts went into default in December 2007. The market’s ongoing problems and the recession further cut into the value of the trusts, which held just $5.3 million in March when Depfa sought to withdraw the funds as permitted under the loan agreements.

The districts expected to benefit financially by capturing the spread between the low rate it paid on the notes and the higher rate of return it expected on its investments.

The districts put up their moral obligation pledge to cure any deficiency in value of the trusts should the worth of its assets fall below 101% of the principal amount of the notes.

Depfa sought to renegotiate the loans but without an agreement in hand last March sent the districts a default acceleration notice and demanded repayment in the districts’ next budgets.

The Waukesha downgrade affects $12 million of outstanding GO debt.

The district’s rating is supported by a relatively strong credit profile characterized by a large, wealthy tax base and limited debt and incorporates the risk posed by the moral obligation notes on the district’s operating budget.

“The negative outlook is based on the unresolved litigation through which the district expects to resolve its various liabilities under the investment structure, including the moral obligation tied to the asset-backed notes,” Moody’s wrote.

The district owes another $15.7 million of note anticipation notes related to the investment. Those notes come due in September 2011.

Clifton said the district intends to refinance the notes.

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